The damage already done by the debt ceiling debate

By Felix Salmon
July 14, 2011
such an inchoate mess that it increasingly seems as though no deal will get done at all.

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Listen to anybody on Capitol Hill, and they’ll tell you that the debt ceiling debate is turning into a complete disaster, with the Republican rank and file such an inchoate mess that it increasingly seems as though no deal will get done at all. Look at the Treasury market, however, where the 10-year bond currently yields something less than 3%, and it looks decidedly sanguine; short-term debt maturing shortly after the drop-dead date of August 2 is similarly unaffected by the news from Washington.

Megan McCardle thinks this shows a “giant disconnect” between Wall Street and Washington — things which Wall Street thinks are easy turn out in reality to be extremely hard, and things which any Wall Streeter would just do as a matter of course can be de facto impossible when political posturing starts getting in the way.

I’m not sure the disconnect is all that huge, for a couple of reasons. For one thing, US default risk is impossible to hedge. US default is an end-of-the-world event, and markets by their nature can’t price such things. Conceptually, there’s no point in buying something which pays off if the world ends, since the world will have ended at that point, and in any case your counterparty won’t be able to make good on the contract.

On top of that, remember that we already hit the debt ceiling on May 16two months ago. Since then, the amount of outstanding Treasury securities — a number which normally rises steadily — has been stuck at $14.3 trillion. The fact that supply of Treasuries has been artificially constrained by the debt ceiling has surely, at the margin, helped to support prices.

And more generally there are still a lot of individuals and institutions who want to buy Treasury bonds. That number might have been falling in recent weeks, but it’s still large. The U.S. is not facing the kind of emergency we’re seeing in the eurozone, where countries want to borrow money but no one’s willing to lend to them. If Treasury asks to borrow money from the markets, the markets will always lend it money; the only question is how much interest they will charge.

This is where McArdle goes awry, incidentally: she’s worried that any new debt issued after August 2 won’t be able to find buyers if Congress doesn’t raise the debt ceiling. But there will always be buyers, and there will always be buyers at yields very, very close to the secondary-market price for Treasury bonds. Treasury bonds are fungible, and to underscore that fact Treasury could easily just reopen old bond issuances instead of creating new ones. That would ensure that there was no way of telling the difference between bonds issued “legally” and bonds issued after the debt ceiling was breached.

Even if Treasury can still sell bonds, however, that doesn’t mean for a minute that breaching the debt ceiling is something which should be considered possible for the purposes of the current negotiation. Tools like the 14th Amendment or even crazier loopholes like coin seignorage would be signs of the utter failure of the US political system and civil society. And that alone could mean the loss of America’s status as a safe haven and a reserve currency. The present value of such a loss? Much bigger than $2 trillion. (Coin seignorage, if you’re wondering, is the right that Treasury has to mint a couple of one-ounce, $1 trillion coins and deposit those coins in its account at the New York Fed. It could then withdraw cash from that Fed account to make all the payments it wanted.)

This is one reason why I worry a lot about clever ideas like Mitch McConnell’s plan to get the debt limit raised through a novel use of the Presidential veto — or, for that matter, Matt Yglesias’s even cleverer plan for Democrats to game the McConnell scheme. McConnell is one of Congress’ foremost tacticians, but cunning tactics on either side of the aisle are the last thing that anybody needs right now.

When Bob Rubin did a nifty sidestep around Congress and magicked Mexico’s bailout billions from some dusty account no one knew about, he was playing a dangerous game. When Hank Paulson and Ben Bernanke stretched the limits of their powers almost beyond the legal breaking point during the financial crisis, their actions were understandable but also set yet another precedent. And so now, when there’s no immediate emergency at all, people are looking to the executive branch to find a way to do the right thing, and thereby giving Congress implicit permission to play out and generally behave with all the maturity of a group of rampaging destructive adolescents.

The base-case scenario is, still, that the debt ceiling will be raised, somehow. But already an enormous amount of damage has been done: the US Congress has demonstrated clearly that it can’t be trusted to govern the country in a responsible manner. And the tail-risk implications for markets are huge. Think of the speed with which the Egyptian government collapsed earlier this year, or the incredible downward velocity of News Corporation right now. When you build up large stocks of mistrust and ill will, nothing can happen for a very long time. But when something does happen, it’s much quicker and much worse than anybody could have anticipated. The markets might not be punishing the US government at the moment. But the mistrust and ill will is there, believe me. And when it appears, it will appear with a vengeance.


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“[T]he US Congress has demonstrated clearly that it can’t be trusted to govern the country in a responsible manner”?

And the Presidency. Since when is slashing aggregate demand in the middle of a never-ending recession is “responsible”?

Posted by lambertstrether | Report as abusive

Great post. One question I have though, is about US default risk being impossible to hedge. Sure, buying CDS as insurance is idiotic, because it carries counterparty risk and a US default would be the ultimate counterparty risk mushroom cloud. But what about gold? The price of gold is still surging, especially recently.

Now, when it spiked the other day (along with the stock market) people thought it was due to the QE3 talk, but Bernanke’s latest comments haven’t caused a selloff in gold (though equities is maybe another matter… although I realize that attributing a market ramp or selloff to one cause is normally not helpful).

So I just sort of throw this out there: gold is the only thing that really hedges counterparty risk, so it would seem to be the logical choice for anyone who wants to hedge a US default even just a teeny tiny little bit. (I.e., there’s no point in really piling into a hedge of that size, but you could throw some money into it in case the asteroid does strike and there’s enough civilization left standing for your hedge to still have vallue).

Posted by jon.stokes | Report as abusive

The bond market is sanguine because it is certain that bond coupons will be paid. The White House has made this perfectly clear through a series of stage whispers, most recently and most blatantly Obama’s observation that Social Security checks might not go out on time. Did he say anything about bond payments? He did not. Social Security is negotiable. Coupons are not.

A lot of bad things could happen in the next couple of months, but bond payments will be made on time and in full. I bet Treasury would even do that thing with stricking platinum coins if they had to. The odds of a default in August are as close to zero as can be measured.

Now, if I were on Social Security…I might be just a bit more concerned. But the GOP balked at the last shutdown crisis, and I can’t see any reason to think they’ll stand firm on this one.

Posted by ckbryant | Report as abusive

US default is hard to hedge if you don’t own Treasury securities. If you do own them, selling them would seem at least partly to hedge against that event.

If the Bowles-Simpson recommendations were combined with a $15T debt limit, how long would that give us until we needed to go through this again? That would seem at least to be a good starting point / benchmark.

Incidentally, Boehner can lose 23 Republicans before he starts needing Democrats. Obama, contrary to your attempt to portray him as agreeable beyond reproach, is probably not going to back anything that won’t lose more than 23 Republicans. Whatever gets agreed to is going to have a lot of Democrats in the House voting for it; Boehner would like to have as many Republicans as possible for political reasons, but he won’t have 217 of them.

Posted by dWj | Report as abusive

Right now, the debt ceiling isn’t being raised, because one segment (the ones who have absolutely no idea how anything works, and just plain believe in magic) of the Republican party doesn’t want to, unless lots of concessions are made by the Democrats. However, there are Republicans in the house who are Republican mainly because they don’t like paying taxes, and still want to be able to make money so they can complain about paying taxes, so they will support, with most of the Democrats in the house, a bill that only raises the debt ceiling, because they know if the debt ceiling isn’t raised and all hell breaks loose, they won’t be making any money to not pay taxes on.

Throughout the first two years of his presidency, Obama was willing to make deals with his own party, and enough of them refused such that he couldn’t get what he wanted passed without the votes of some Republicans. So he tried to make deals with some of the Republicans, but they refused. The net result was very little useful legislation, and his party lost a lot of seats in 2010.

Now Obama is willing to make deals with Republicans, but they are digging their heels in quicksand. At the last minute, enough of them will vote for the increased debt ceiling, but will get nothing in return, except scorn from voters in 2012. Or, if there is no vote, everybody gets nothing.

Posted by KenG_CA | Report as abusive

the US Congress has demonstrated clearly that it can’t be trusted to govern the country…

Well, that’s what we elect a President to do.

Posted by krugginator | Report as abusive

@jon.stokes. Re: gold as hedge: why not other commodities? Or are you party to the same delusion as Ron Paul that just because gold was money for a long while previously, it will be accepted in the grocery store tomorrow? And what would you buy? Buying physical gold implies massive haircuts/transaction fees in both directions. Buying gold ETF is just as much counterparty risk as everything else.

@dWj: when you sell Treasuries, you get dollars in return. What would be the point?

Posted by Y.Alekseyev | Report as abusive

No one is really that worried because the debt ceiling was always raised. (and the price of houses always went up)

Goldman has said do not worry, it is all smoke and mirrors and even made a chart to prove it! No one could possibly be hurt (forget the poor,elderly, unemployed and ill as they never count for republicans and TBTF banks)

With the revolving door between Government, treasury, fed reserve and Wall street I would say there is, in fact, a pretty big “connect,” but knowing bonds will be paid is the reason no one is panicking yet.

The 2008 recession was a walk in the park if USA defaults, but the Republicans remain firm that those “job creating” rich get their tax credits and loopholes, so they will bear no guilt!

I think the republicans forget how many of their Tparty backers might be on SS and Obama was just reminding them. Pass the popcorn, please … it’s showtime!

Posted by hsvkitty | Report as abusive

Coin seigniorage is not a real loophole. It is what banana economies do when their revenues don’t match their spending and they can’t borrow money. Classic examples: Zimbabwe 2001-09, Russia 1991-94, Weimar Germany 1922-23. The problem is that financing budget deficit through seigniorage rapidly increases money supply and eventually triggers hyperinflation. If the government were to “coin” and spend $2T, which is more than M1 and around 20% of M2, that would create a major disruption in financial markets.

The Fed would be able to control the inflation of money supply for a while by selling off its reserve assets, of which it has about $2.5T at the moment, and but soon it would run out.

Trying to balance the budget via seigniorage is playing with fire.

Posted by Nameless | Report as abusive

I think that the bigger damage is to the concept of democracy in general. I’m an American living in China, and the incompetence of the current Congress is making democracy seem rather unattractive.

People over here laugh at the idea that someone as stupid as Sarah Palin could even get close to the reins of power, noting rightfully that while China may still be a dictatorship, at least its run by competent and intelligent people.

Posted by mfw13 | Report as abusive

@krugginator – The President alone, cannot unilaterally act to govern; that’s a dictatorship like that which mfw13 seems to relish in China.

Congress, as the third pillar in the checks and balances system, must cooperate, and the Supreme Court must provide tacit or implied approval. The cogs in the system are there to prevent dictatorships and unilateral decision making.

MFW13 may enjoy dictatorial decision-making, but what if that was a Tea Party supporter making unilateral decisions as a President? In a dictatorship, how would you get rid of that Tea Party dictator?

Republicans blocking the debt cap is the sometimes messy result when a side has determined that it IS the dictator of terms. To which end, democracy triumphs, because recalls and elections allow Americans to throw these people out of office, if they choose to do so.

Such threat of being thrown from office gives Americans the power to redirect elected officials by way of communicating their desires. The problem is, the rhetoric hasn’t yet changed the minds of the majority of people, because its representatives have not yet effectively won the battle of rhetoric.

Sometimes you get a Pearl Harbor, because the group thinking fails to change in time. So be it: I’d still rather have a messy democracy than an imposing dictatorship.

Posted by GRRR | Report as abusive

When will Americans stop backing this two party nightmare. They only reason they get away with such foolishness is because there are enough Americans who will follow their party no matter what. Time to start backing people of intelligence and integrity regardless of party. Once the parties realize that their die hard fans will walk away, they will change. How much more damage must they do?

Posted by actnow | Report as abusive

Two things really bug me here: Debt ceiling and budgets are supposed to be passed through congress, but this congress is completely unwilling to go through normal legislative measures to get bills passed. Instead they drag in the president into the legislation process (where he has no place really) and lay the blame at his feet if anything goes wrong – atrocious behaviour. The other thing that bugs me is that potentially a criminal organization (ie Fox News) is about the only outfit giving the Republican party any legitimacy whatsoever. The winds of change blew strong in 2008… then Fox News blew back and helped put in power people who had no business being there and helped block legislation that the country sorely wanted (and needed!). If all goes wrong for News Corp in the coming months and years I wonder how those that reside in that echo chamber will feel about how they’ve acted during these times.

Posted by CDN_Rebel | Report as abusive

Would also like to say that there needs to be three political parties in America: The progressives (the socialist block of Dems – not a bad thing), the centrists (the majority of both the Repubs and Dems), and the TPers (the far right libertarian anarchists). Until that happens then people in America are really not being represented, they are just picking parties based on single (minor) issues rather than true ideology.

Posted by CDN_Rebel | Report as abusive

Our Political Leaders need to stop holding a gun to the heads of US Taxpayers and Senior Citizens and get this s#!^ fixed.

Obama is done for, Congress is disorganized, and the Federal Reserve is clueless. The people who need to know how to respond in a crisis, are creating the crisis itself.

Posted by gmroder | Report as abusive

@GRRR….if you are going to discuss my comments, please at least do so accurately, instead of sticking words in my mouth which I never said.

My point, which you seem to have missed completely, is that China, while a dictatorship, is also a meritocracy. For the most part (there is some nepotism), you do not get to a position of power within the CCP unless you are pretty damn smart. So people with the intelligence level of most Tea Party members would never be able to achieve power in China. Probably two-thirds of the members of Congress would not even be deemed intelligent enough to join the CCP.

In the US, things often get debated to death and nothing gets done…in China things don’t get debated (although issue are dicussed vigorously within the CCP), but things get done. So it’s a mistake to think that one approach is universally better than the other. They both have aspects that are good and bad.

But let’s face it….if today’s GOP was in power in the 1950′s, the interstate highway system would never have gotten built…

Posted by mfw13 | Report as abusive

mfw13 are the Chinese also laughing because we put into office a man who’s never run a business and has been in office for less than two years? I agree that Sarah Palin should not run for office but at least she has leadership and business experience.
It amazes me how this country overlooked the experience factor and elected Obama mostly because he’s a smooth talker, good looking and because he would be the first black president and they did this during economic turmoil. This is a good reason for the Chinese to laugh at us.

Posted by jorge62 | Report as abusive

Part of the problem is that Congress does not have the accountability that it should have. As long as we USA citizens are apathetic, our rule makers will feel like they can do just anything they want. Then come the next election – stay on the good side of the news media, get a lot of money from your backers (who expect to get repaid) buy advertising time from the media, count on voters that will believe the sound bites and get reelected.

Posted by richinnc | Report as abusive

If the Obama administration had been as interested in solving the financial crisis as it was passing Obamacare, we wouldn’t be in this mess. Many Republicans were elected as a result of Obamacare being pushed down everyone’s throat. The Democrats have only themselves to blame for this. They wasted their supermajority on an unpopular program so Obama could make history.

Posted by moonhill | Report as abusive

@moonhill, if Obamacare was passed with the people in mind, it would have been good for everyone. Perhaps the shaping legislation should be for the common good, not ALEC. sabotaging-healthcare

I would say your mess was pretty well ensconced by Bush when he took your country and many others to war paid for in debt. And giving tax breaks while going to war was plain stupid. Republicans were elected because the American populace jumped on the propaganda bandwagons and will again.

You are not only broke, you can’t pay the interest. i would say a country that is defaulting (yes I said you already defaulted when you are borrowing to pay interest)should have Republicans doing the right thing and look for revenue and not just cuts.

Being you enjoyed the lowest taxes ever, whilst being in a recession that could have been as bad as the great Depression (and could still go there) perhaps it is time ludicrous ideology didn’t trump common sense.

Posted by hsvkitty | Report as abusive

hsvkitty, so you think someone who doesn’t make their mortgage is good standing and someone who has never missed a payment has defaulted. Glad to see your genius showing through yet again.

Mr Salmon, thought you were a fan of people who dont pay their loans back

Posted by Danny_Black | Report as abusive

mfw13, are you on crack? China is a kleptocracy that is running out of people to steal from. They have a real estate bubble that makes the one in the US look like a walk in the park and recently had to bail out their local goverments to the tune of 10% of annual GDP. Random things get done in China depending on who you can bribe, who you can steal from and who you are related to. I believe Hitler got the trains to run on time too….

jorge62, they voted for a guy who none of the media would say a bad word about, actively hid anything negative whilst printing any old BS the opposition had including obvious hoaxes. Given it was in the middle of an economic meltdown, with a highly unpopular republican president and the fact he had the black population sewn up I suspect if the Democrats had slapped a rosette on an actually donkey it would have won.

Posted by Danny_Black | Report as abusive

Danny_Black, I never said I supported all those who were in default… NOR did I say they were in good standing, so ST*U you pain in the derriere. I notice when the other banker who writes here said he would walk away from his mortgage if he lost his job, you never said a word… but couldn’t find an ounce of support for those being foreclosed upon with fraudulent documents or being lied to about HAMP.

The USA is paying debt with debt, so yes, I consider that a default. Do you consider paying your bills with a credit card a payment? (Oh hell, what am I saying, as a former banker you do)

That is why banks and governments say that their financing and budgets are not like ours… because we could never get away with such folly… but neither eventually (or all too soon) will they.

Posted by hsvkitty | Report as abusive

Danny, you’re thinking of Mussolini, but yeah. Now will everyone quit piling on mfw13. I understood his post as a summary of what his Chinese friends were saying, not necessarily his own best effort at defending non-democratic political systems. And for all we know, 13 may be his age.

If there were an unintelligent person in the Chinese leadership, how would we know, considering that information doesn’t flow freely?

I have some experience of living in countries that aren’t democracies or aren’t full-fledged democracies. Sure, from time to time people there really do say, and mean, things like “We need our own Pinochet” or “You can’t have a free press in Asian countries” or whatever — but I think that mostly has to do with believing they can’t change the situation themselves.

Now instead of beefing about things like who is in favor of dictatorship, or whether or not we like Obama and why, the logical conclusion is that it is on us (at least, adult American us, the rest of you can just sit back and throw brickbats) to get these dunderheads out of here if they can’t accomplish the simplest things.

Posted by SelenesMom | Report as abusive

Salmon isn’t much of a negotiator and I wouldn’t want him anywhere near crucial negotiation. I could see his palms sweat and his eyes twitch in between sentences.

The big problem with this piece is it isolates out the debt ceiling from the debt. That wrenches the current negotiations out of the context of federal government spending and taxation. That’s a killing mistake and makes this piece worthless.

Let me add some of that back in and maybe Salmon can start to make sense of what’s going on.

The USFG is projected by everyone to take rapidly increasing shares of the US GNP under even very optimistic assumptions. That’s a certain catastrophe for this economy: economists estimate that 25-35% of GNP for all levels of government maximizes growth. Under Democratic proposals and baselines, the USFG takes at least that amount, just for itself, for decades to come. That is a catastrophe for economic growth: it entombs our economy in a permanent rotting decay.

That problem isn’t solved with more tax revenue, it is exacerbated. Because it is certain that politician-weasels will spend every penny of revenue and use more revenue to leverage even more spending. There is NO prospect that Obama or the Democrats would make any substantial spending cuts in the foreseeable future. The Obama budget that was unanimously defeated this Spring increased spending across the board, in fact.

The debt is a related, but distinct issue from the total portion of the economy that politicians take to hand over to their cronies. And escalating debt also crushes the future by undermining economic growth. More importantly, my son is 1 year old and unless we take action, his life chances will be substantially undermined. He and your sons and daughters will be handed massive debt that they will have to pay back. That is, by my account, evil. What sort of moral disaster thinks its ok to consume today and force their children to pay for that consumption the rest of their lives? Evil.

This moment is a chance to do something meaningful about both of those problems. To scale back the size of the federal government and to meaningfully lower federal debt. Felix Salmon, Megan McCardle, Harry Reid, and Barack Obama need to think things through, this one time, and do the right thing, this one time. Instead of what they are doing.

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